The Mind of an Institutional Investor

Water: The medium is the message

Nearly 20 years ago, when derivatives were still relatively new and exotic, I was an honored guest at an asset management conference. It was one of those events where you worked tremendously hard from about 7 am until after lunch, and were then free to relax. If I remember correctly, it was in Carmel, California and many people went to play golf or shop; two sports I don’t play. So, instead, I worked out in the gym and then, around 5 pm, went to the hot tub to relax some aching muscles. I was joined there by the head of the company’s London swap desk. We engaged in a spirited discussion and that was that. Or so I thought.

The next morning, she was the first speaker. Remember, derivatives were unfamiliar and scary to most people. She walked to the podium and began by saying “I learned something important about derivatives from Jon Lukomnik last night.” Sitting in the audience, I immediately puffed up, cartoonishly proud that I could teach the expert something. “What I learned,” she then deadpanned, “was that any conversation about derivatives is much more pleasant in a hot tub.” Of course, I immediately deflated. But the lesson she taught has stayed with me two decades later: When and how you have a conversation matters.

I was reminded of that last week. Together with other institutional investors, we were in a floor-through glass fishbowl of a conference facility, some 42 stories up in the iconic HSBC building, overlooking the Hong Kong harbor. After three days in Bejing, we had already heard about the development of the Chinese asset management market, regulatory reform, macroeconomics, private equity, dim sum bonds, etc. The afternoon at HSBC promised more of the same – presentations that were high quality and thought provoking. We heard about current global market conditions, Chinese economics and even a presentation about gambling in Macau. Then something unforeseen happened. Debra Tan, a former accountant, stepped to the podium and began speaking about water risk in China. Slowly, with an auditor’s precision, she detailed how a lack of water was threatening China’s economic rise, how the most at-risk provinces were the most productive agricultural and industrial areas, how China was already at work on a $62 billion project to divert water from the South to the North (a stopgap even if it works), how some manufacturers had to halt production in a particular city when the power company couldn’t provide power because of a lack of water, etc.

The statistics were powerful: People in Bejing have less water per capita than Palestinians in the West Bank. 40% of China’s food production comes from water-stressed areas. Nearly 53% of China’s industrial output is produced by water scarce regions. The average person throughout china has about one-fifth the fresh water availability of an American. Water input costs for manufacturing are expected to rise by a factor of three to five times in just a few years.

If the facts were startling, the implications were frightening, not just for China, but for the global economy and, potentially, for the geo-political situation. The World Bank predicts 30 million internal Chinese “water refugees,” fleeing water stress in China within this decade. China itself said that extreme weather, including water issues, killed nearly 5,000 people last year and low water levels cause the Yangtze River (China’s major waterway) to close to shipping once already this year.

The American institutional investors who filled the room were as silent as they had been all day. These were not dedicated socially responsible investing types, but mainstream mutual fund and insurance professionals. The potential extreme implications slowly dawned on us. China’s size and scale is vast. It is the world’s largest agricultural producer; to use one small agricultural example, it produces more potatoes than the US, Russia and Germany, combined. If it has agricultural problems caused by water issues, world food prices are heading up. It is the world’s second largest economy. If it can’t produce or consume because of freshwater scarcity, the world economy will suffer. In the worst case, we could see a new set of global security issues arise from “water wars”, as rivers that flow from China are major sources of freshwater from India, Pakistan, Laos, Thailand, Cambodia, Vietnam, Bangladesh and Myanmar.

OK, Ms. Tan’s purpose was to shock us out of our complacency. She succeeded. But I, for one, think that what was most shocking was the site of the presentation. This wasn’t a meeting of environmentalists or even one of the many groups that try to link investors to climate issues, such as the UNEP FI or the CERES coalition. It was an HSBC presentation. And, as if to emphasize that fact, the very next day the same group heard a presentation from a competing firm, CLSA, which included a slide on water worries and Chinese agriculture.

In the end then, the most impressive fact might not be any of those presented by Ms. Tan. It might be that both HSBC and CLSA included water as a major risk factor – one generally ignored by most institutional investors – in mainstream presentations to mainstream investors. Where, and how, you have a conversation does matter. Perhaps it’s time to start worrying.